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Tuesday, October 27, 2015

Readers of The Insurance Forum over the years, and readers of chapter 25 of my new book entitled The Insurance Forum: A Memoir, know I take a dim view of surplus notes. Those bizarre financial instruments represent debt, but the insurance company that borrows the money is not required to establish a liability. Thus the amount borrowed is treated as an asset and increases the company's surplus.

Most of the insurance company executives who decide to issue surplus notes, and most of the state insurance regulators who approve the issuance of surplus notes, will be long gone when the debt comes due and has to be repaid. That is just one of the reasons why I call surplus notes a classic example of a WWNBA transaction: We Will Not Be Around.

Another Dimension of Surplus Notes
For several years, Senior Health Insurance Company of Pennsylvania (SHIP) has been running off the long-term care insurance business of a former subsidiary of what at the time was Conseco, Inc. In August 2015, a reader sent me—out of the blue—SHIP's statutory statement as of December 31, 2014. My reader did not say why he sent me the statement, but he may have done so because he was aware of my keen interest in surplus notes.

The statement reflects the recent issuance of a $50 million surplus note. As indicated in the "Notes to Financial Statements," the interest rate on the surplus note is 6 percent, and the maturity date is April 1, 2020. Thus the maturity date is five years away, in contrast to the 20-year or 30-year maturities of most surplus notes. SHIP issued the surplus note to (in other words, borrowed the money from) Beechwood Re Investments, LLC, a unit of Beechwood Bermuda International, Ltd. (Hamilton, Bermuda).

The big surprise was that the surplus note was issued February 19, 2015, seven weeks after the "as of" date of the 2014 statement. The statement, which had to be filed around March 1, 2015, did not show the $50 million surplus note as an asset; instead, the statement showed a $50 million surplus note receivable as an asset, which in turn increased SHIP's surplus by $50 million.

I asked Patrick Carmody, senior vice president and general counsel of SHIP, whether the Pennsylvania Insurance Department had approved the inclusion of the surplus note receivable as an asset in the 2014 statement. Carmody graciously provided a copy of a letter dated February 12, 2015, to Brian Wegner, president and chief executive officer of SHIP, from Stephen Johnson, deputy insurance commissioner in the Pennsylvania Department. Johnson granted SHIP's request to issue the surplus note no later than February 15, 2015. (SHIP missed that date by four days.) Johnson's letter also said:

Additional approval is granted for the transaction to be booked with a December 31, 2014 effective date, in accordance with SSAP 72, paragraph 8. As required by SSAP 72, paragraph 8, the company must submit to the Department evidence that the surplus note receivable was collected in cash prior to filing the company's financial statement as of December 31, 2014. The transaction must also be disclosed as a Type I subsequent event, in accordance with SSAP 9, in the company's financial statement as of December 31, 2014. To the extent any of the surplus note receivable is not collected prior to the filing of the financial statement as of December 31, 2014, it shall be non-admitted.

SSAPs (Statements of Statutory Accounting Principles) are promulgated by the National Association of Insurance Commissioners (NAIC). I wondered about the exact language of the two SSAPs referred to in the Johnson letter. Here is paragraph 8 of SSAP No. 72:

Notes or other receivables received as additional capital contributions satisfied by receipt of cash or readily marketable securities prior to the filing of the statutory financial statement shall be treated as a Type I subsequent event in accordance with SSAP No. 9 and as such shall be considered an admitted asset based on the evidence of collection and approval of the domiciliary commissioner. To the extent that the notes or other receivables are not satisfied, they shall be nonadmitted.

Type I: Events or transactions that provide additional evidence with respect to conditions that existed at the date of the balance sheet, including the estimates inherent in the process of preparing financial statements.

Type II: Events or transactions that provide evidence with respect to conditions that did not exist at the balance sheet date but arose after that date.

SHIP's Explanation of the Problem
SHIP's 2014 statement shows a net loss of $56 million in 2014, compared with a $3 million net loss in 2013. When I asked Carmody for the Department's letter, I also inquired about the primary drivers of the relatively large net loss in 2014. The response, from a senior paralegal writing on behalf of Carmody, is somewhat technical. However, I show it here for those readers who will understand it:

2014 results were impacted by reserves [sic] changes in the Company's "TLI" book of business. Actual-to-Expected ratios did not decline as much as expected and reserves were adjusted accordingly. Those ratios are showing signs of declining in 2015. Financial projections continue to show lifetime solvency, therefore the Company is continuing to refrain from seeking rate increases; its mission is to serve the interests of the policyholders, not to accumulate surplus.

SHIP's Risk-Based Capital
SHIP's risk-based capital (RBC) numbers show what may have prompted the issuance of the surplus note. Here is the relationship between each RBC "level" and company action level: company action level is 100 percent, regulatory action level is 75 percent, authorized control level is 50 percent, and mandatory control level is 35 percent.

SHIP's total adjusted capital as shown in the 2014 statement, which was filed around March 1, 2015, was $118 million. Its company action level was $109 million. Therefore SHIP's RBC ratio was 108 percent ($118 million divided by $109 million, with the quotient expressed as a percentage), and was slightly above company action level of 100 percent.

Consider the situation, however, without the $50 million capital contribution that resulted from showing the surplus note receivable as an asset. SHIP's total adjusted capital would have been $68 million ($118 million minus $50 million). Therefore SHIP's RBC ratio would have been 62 percent ($68 million divided by $109 million, with the quotient expressed as a percentage). Thus SHIP's RBC ratio would have been below regulatory action level of 75 percent but above authorized control level of 50 percent.

General Observations
It is likely that SHIP discovered—while preparing its 2014 statement early in 2015—that its RBC ratio was below regulatory action level. That normally would trigger a regulatory investigation. To avoid such an investigation, SHIP needed what was in essence a backdated contribution to its total adjusted capital to improve its RBC ratio.

It is also likely that SHIP discussed the matter with the Pennsylvania Department immediately upon discovering the problem. The Department may have suggested the idea of issuing a surplus note and showing the "surplus note receivable" as an asset. An alternative would have been for Beechwood to backdate the surplus note to December 31, 2014. However, it is possible that state insurance regulators prefer an "in essence" backdated capital contribution rather than a truly backdated capital contribution. I dislike backdating in any form, because it falsely portrays a company's year-end financial condition.

When this item is posted, I will send it to the NAIC and ask the following questions. (1) Do you agree with me that a backdated capital contribution falsely portrays the financial condition of a company as of the statement date? If you disagree with me, please explain. (2) When did you begin allowing backdated capital contributions (the two SSAPs discussed here were effective January 1, 2001)? (3) Why do you allow backdated capital contributions? (4) Are banks and other regulated financial institutions allowed to accept backdated capital contributions? Also, I will tell the NAIC that I will report its responses in a future blog post.

Available Material
For readers who want to see the relevant items in SHIP's 2014 annual statement, I am offering a complimentary 51-page PDF of the statement. E-mail jmbelth@gmail.com and ask for SHIP's 2014 statement. The relevant items are the sworn statement at the bottom of page 1, lines 25 and 2501 on page 2, line 32 on page 3, lines 35 and 48 on page 4, paragraph 13(11) on page 19.12 (page 30 of the PDF), and lines 30 and 31 on page 22 (page 45 of the PDF).

Thursday, October 22, 2015

On October 13, 2015, MetLife, Inc. (NYSE:MET) filed an 8-K (material event) report with the Securities and Exchange Commission. The report provides a classic example of the perennial confusion over the denominator used in calculating risk-based capital (RBC) ratios.

The Nature of the Confusion
An RBC ratio is a comparison of two numbers. The numerator of the ratio is "total adjusted capital" (TAC), which is the company's net worth with a few adjustments. The denominator of the ratio, in theory, could be any of the several RBC "levels." However, companies invariably use either "company action level" (CAL) or "authorized control level" (ACL). CAL is exactly twice ACL.

The responsibility for the confusion rests with the National Association of Insurance Commissioners, which made a politically motivated change when the RBC system was adopted in the early 1990s. I discussed the problem on pages 308-310 in my recently published book, The Insurance Forum: A Memoir. I concluded the discussion there by saying that one thing is certain: whenever an RBC ratio is mentioned, it is essential to indicate what RBC level was used as the denominator.

The Language in the 8-K Report
In the recent 8-K report, MetLife said its "Combined RBC Ratio" at the end of 2014 was 398 percent "instead of in excess of 400% as previously reported in the 2014 10-K and 410% as previously communicated on the Company's first quarter 2015 earnings call." I do not know what was said on the earnings call, but the recent 8-K report did not say what denominator was used in calculating the combined RBC ratio.

To find out, I reviewed MetLife's 10-K report for the year ended December 31, 2014. I found the answer buried on page 299 of the 361-page 10-K report. The denominator was CAL.

The Language in the 10-K Report
One paragraph in the 10-K report explains the RBC system. It is necessary to read the entire paragraph carefully to learn that CAL was the denominator used in the combined RBC ratios mentioned in the recent 8-K report. Here is the full paragraph:

The states of domicile of MetLife, Inc.'s U.S. insurance subsidiaries imposes [sic] risk-based capital ("RBC") requirements that were developed by the National Association of Insurance Commissioners ("NAIC"). American Life does not write business in Delaware or any other domestic state and, as such, is exempt from RBC requirements by Delaware law. Regulatory compliance is determined by a ratio of a company's total adjusted capital, calculated in the manner prescribed by the NAIC ("TAC") to its authorized control level RBC, calculated in the manner prescribed by the NAIC ("ACL RBC"). Companies below specific trigger levels or ratios are classified by their respective levels, each of which requires specified corrective action. The minimum level of TAC before corrective action commences is twice ACL RBC ("Company Action RBC"). While not required by or filed with insurance regulators, the Company also calculates an internally defined combined RBC ratio ("Combined RBC Ratio"), which is determined by dividing the sum of TAC for MetLife, Inc.'s principal U.S. insurance subsidiaries excluding American Life, by the sum of Company Action RBC for such subsidiaries. The Company's Combined RBC Ratio was in excess of 400% for all periods presented. In addition, all non-exempted U.S. insurance subsidiaries individually exceeded Company Action RBC for all periods presented.

An Omission from the 10-K
MetLife did not disclose in the 2014 10-K report the CAL RBC ratios for its principal U.S. insurance subsidiaries. To calculate the figures, it is necessary to obtain—from the statutory annual statement for each subsidiary—TAC and ACL, multiply ACL by two to determine CAL, divide TAC by CAL, and express the quotient as a percentage.

Although the combined CAL RBC ratio was 398 percent, according to the recent 8-K report, there may be a wide range of CAL RBC ratios among MetLife's principal U.S. subsidiaries. To get an inkling of the range, I reviewed the year-end 2014 statutory annual statements of three subsidiaries. Here are the TAC, CAL, and CAL RBC ratios:

Company

TAC

CAL

Ratio

(in millions)

(in millions)

(%)

---------------

---------------

-------

MetLife Ins Co USA

$6,710

$1,527

439

Metropolitan Life Ins Co

17,367

4,576

380

Metropolitan Tower Life Ins Co

836

230

363

----------

---------

-------

Three Companies Combined

$24,913

$6,333

393

The CAL RBC ratios for the three subsidiaries are all comfortably in the adequate zone; that is, they are all well above the CAL RBC ratio of 125 percent, which is the "red flag level." Thus no type of corrective action is necessary.

Also, as indicated in the table above, I calculated the combined CAL RBC ratio for the three subsidiaries, using the methodology described in the quoted paragraph from the 2014 10-K report. The combined CAL RBC ratio for the three subsidiaries is 393 percent, which is close to the 398 percent combined CAL RBC ratio cited in the recent 8-K report for all the principal U.S. subsidiaries of MetLife other than American Life.

Availability of My New Book
Ordering information for The Insurance Forum: A Memoir is available at www.theinsuranceforum.com. The book is also available from Amazon.

Monday, October 19, 2015

In 2003 I wrote extensively in The Insurance Forum about cost-of-insurance (COI) increases imposed by an operating subsidiary of Conseco, Inc. on owners of certain policies Conseco had acquired from other companies. Later I wrote extensively in the Forum and on my blog about COI increases imposed by operating subsidiaries of The Phoenix Companies, Inc. on owners of certain policies involved in stranger-originated life insurance (STOLI) transactions. Recently COI increases appear to be spreading among other companies.

Conseco's COI Increases
The Conseco story began in 1992, when Massachusetts General Life Insurance Company and Philadelphia Life Insurance Company imposed COI increases on certain universal life policies. A policyholder sued the companies alleging they had breached their contracts. A federal judge ruled the companies had breached their contracts, the case was converted to a class action, the class was certified, the case was settled, and the companies rolled back the COI increases. Conseco acquired Massachusetts General and Philadelphia Life in the late 1990s. The unanswered question is whether Conseco officials were aware that the policies they acquired had been significantly underpriced for sales purposes and were a disaster waiting to happen.

In 2003 Conseco launched an assault on its policyholders by imposing sharp COI increases. One example: the COI on a $1,000,000 policy issued in 1988 to a man aged 52 increased from $373.78 per month to $1,484.05 per month. Another example: the COI on a $250,000 policy issued in 1987 to a man aged 56 increased from $26.65 per month to $349.81 per month. Litigation ensued. Eventually the cases were settled, and the policyholders were awarded substantial benefits.

My most extensive material on Conseco's COI increases appeared in the 16-page December 2003 issue of the Forum. The issue was devoted in its entirety to the Conseco story.

Phoenix's COI Increases
In 2010 Phoenix imposed substantial COI increases on the owners of policies of the type used in STOLI transactions. The New York Department of Insurance received complaints and, after an investigation, ordered Phoenix to rescind the COI increases—but only for New York policyholders. Phoenix complied.

In 2011 Phoenix imposed new increases on New York policyholders, and the Department did not object. Meanwhile, insurance regulators in California and Wisconsin ordered Phoenix to rescind the 2010 increases, but Phoenix refused to comply. California dropped the matter, but Wisconsin began legal proceedings that are yet to be finally resolved.

Phoenix was also the target of several lawsuits relating to the COI increases. In May 2015 Phoenix moved to settle two long-standing class action lawsuits just before the trial. The settlement was later approved by the court, and has been completed. Also, Phoenix is in the process of settling some of the other cases.

My major articles in the Forum about Phoenix's COI increases are in the October 2012, December 2012, and November 2013 issues. My three blog posts about Phoenix's COI increases are No. 9 (November 21, 2013), No. 26 (January 29, 2014), and No. 103 (June 15, 2015).

COI Increases at Other Companies
Recently I have learned of announcements by several other companies who are imposing COI increases. The announcements are vague about the magnitude of the increases, and about the reasons for the increases. However, it appears at least some increases will be substantial, and at least some increases are caused by increased prices of reinsurance or low market interest rates. Furthermore, it appears at least some increases apply to policies of $1 million or more issued at ages 70 and above. Among the companies imposing COI increases are AXA Equitable Life, Banner Life, Security Life of Denver, Transamerica Life, and William Penn Life.

Nassau's Acquisition of Phoenix
On September 29, 2015, Phoenix announced it was being acquired by Nassau Reinsurance Group Holdings L.P. for $37.50 per share, or an aggregate of $217.2 million. The purchase price represents a 188 percent premium over Phoenix's closing stock price of $13.03 on September 28. Nassau is backed by Golden Gate Capital, a private investment firm. After completion of the acquisition—expected by early 2016—Nassau will contribute $100 million of new capital into Phoenix, which will be a privately held, wholly owned subsidiary of Nassau.

General Observations
I mention Nassau's acquisition of Phoenix here because I think there is a connection between that development and the settlements of the lawsuits against Phoenix relating to the COI increases. The most important settlement, which I discussed in No. 103, occurred almost literally on the courthouse steps just before the trial was to begin. Phoenix had been fighting those lawsuits for years, and also had been fighting to keep confidential many of the documents filed in court in those cases. A few of those documents, however, have been unsealed, as discussed in No. 26. I think Nassau probably had no interest in acquiring a company bogged down in litigation over COI increases.

Available Material
I am offering a complimentary five-page PDF containing the Phoenix press release. E-mail jmbelth@gmail.com and ask for the Phoenix press release dated September 29, 2015. Ordering information for back issues of the Forum is available at www.theinsuranceforum.com.

Wednesday, October 14, 2015

In September 2015, the Federal Insurance Office (FIO) of the U.S. Department of the Treasury issued its Annual Report on the Insurance Industry. The FIO expresses concern about principles-based reserving (PBR) and the related subject of captive reinsurance (sometimes called "shadow insurance"). Here are three excerpts from the Report:

Wholesale adoption of PBR continues to raise concerns, including potential overreliance on an insurer's internal modeling and a shortage of resources and expertise on state insurance regulatory staffs.

State insurance regulators are developing a framework for consistent standards for reinsurance captives that would allow lower-quality assets to support the so-called "redundant reserves" relating to term life and universal life with secondary guarantee products. The Report outlines FIO's concerns about the scope and yet-to-be-determined specific details of the framework, including that reinsurance captives will continue to be established in states competing to serve in that capacity.

While disclosure requirements of life insurers pertaining to cessions of reinsurance captives of reserves related to term and universal life with secondary guarantee products has improved, state insurance regulators do not require public disclosure of the financial statements of reinsurance captives.

The Report is in the form of a 105-page PDF. The first two excerpts above are on page 15 of the PDF, and the third is on page 67. The full discussions of PBR and captive reinsurance are on pages 65-68.

Presumably the discussions of PBR and captive reinsurance are of great interest to members of the American Council of Life Insurers and members of the National Association of Insurance Commissioners. However, I am not aware of any comments on those topics, or about the Report generally, from either of those organizations.

General Observations

I agree with the first excerpt above. I believe that adequate staffing in state insurance departments to handle PBR is not possible.

I also agree with the second excerpt above. The way it is worded in the Report is a polite way of describing what has become a race to the bottom in terms of the rigor of state regulation of insurance companies.

I agree with the third excerpt as far as it goes. However, it is not merely the lack of a requirement for public disclosure of the financial statements of reinsurance captives that concerns me. Rather, I am concerned about the lack of a requirement for public disclosure of the details of the phony assets carried by reinsurance captives. Among those assets are parental guarantees, contingent notes, credit linked notes, variable funding notes, note guarantees, and letters of credit.

If there were rigorous disclosure of the details of those assets, I think regulators would be so embarrassed that they would not approve such assets. Indeed, I think promoters would not even try to get such assets approved. As I have said previously, captive reinsurance is a shell game, and no shell game can survive disclosure.

Available Material

I am offering a complimentary 105-page PDF containing the 2015 Report of the FIO. E-mail jmbelth@gmail.com and ask for the FIO Report issued in September 2015.

Wednesday, October 7, 2015

Robert D. May, CLU, of Bloomington, Indiana, died June 30, 2015, at age 88. Bob was in the life insurance business for more than 50 years and retired several years ago. When I met him in the 1960s, he was an agent for Acacia Mutual Life Insurance Company. His favorite life motto was a quote that has been attributed to Theodore Roosevelt: "People don't care how much you know until they know how much you care."

I became acquainted with Bob shortly after I arrived in Bloomington. The School of Business at Indiana University did not offer preparatory courses for examinations leading to the Chartered Life Underwriter (CLU) designation. However, when the Bloomington chapter of what was then the National Association of Life Underwriters asked me to conduct an off-campus class for aspiring CLUs, I agreed to do so. Bob was in my first group of about ten agents who enrolled in the class, and he was the first of the group to receive the CLU designation. He and I became good friends.

One of Bob's favorite stories involved Elvis J. Stahr, Jr., who served as president of Indiana University from 1962 to 1968. (I always felt an affinity for Stahr because he and I joined Indiana University effective the same day—July 1, 1962.) Bob said he received a telephone call from Stahr out of the blue. Stahr had been invited to join Acacia's board of directors. According to the company's rules, however, a board member had to be an Acacia policyholder. So Stahr had to buy an Acacia policy right away. Knowing Bob, I am sure he did not allow Stahr to buy the smallest possible policy.

When I launched The Insurance Forum at the end of 1973, Bob subscribed immediately, and he remained a subscriber continuously until I closed down the Forum at the end of 2013. A close friend of mine in Bloomington was the first subscriber, and Bob was the second. When my first subscriber died several years later, Bob became my oldest living subscriber in terms of the length of his subscription. Bob often told me he was proud of that distinction.

The last time I saw Bob was on June 9, 2014, when he attended a celebration in Bloomington organized by three academic friends of mine to commemorate the 40 years of The Insurance Forum. It is regrettable that Bob did not live to see The Insurance Forum: A Memoir. I mentioned publication of the book in No. 118, which was posted on September 28, 2015. Bob was a wonderful human being and a dear friend.